Since our first analysis of Sprint Corporation (S) posted September 9, 2013, there have been a number of encouraging developments for the bond holders of the company. Sprint Corporation is one of the most complex credits in the world. Sprint Communications, Inc., the former Sprint Nextel Corporation, is now a subsidiary of parent Sprint Corporation which in turn is 80% owned by SoftBank Corporation (OTCPK:SFTBY), (OTCPK:SFTBF) of Japan and its affiliates. SoftBank's original purchase of 78% of the company was supplemented by the acquisition of an additional 2% stake beginning on August 1, 2013. We summarize the corporate ownership below using SEC filings. This note uses the default probabilities of Sprint Corporation and bond credit spreads of Sprint Communications, Inc. to measure the reward-to-risk ratio on the company's bonds. Today's study incorporates Sprint Communications, Inc. bond price data as of January 10, 2014. A total of 376 trades were reported on 4 fixed-rate non-call bond issues of Sprint Communications, Inc. with trading volume of $43.7 million.
We conclude that Sprint Corporation has made significant progress in re-establishing liquidity via the transaction with SoftBank and that the return to risk ratio for bond holders has significantly improved. We caution investors, however, that risk remains high and that an investment in the bonds of Sprint Corporation is best reserved for those with special insights into the intents of SoftBank regarding the future of Sprint Corporation.
The SoftBank Transaction and Other Recent Transactions
The 10-q filing by Sprint Corporation with the Securities and Exchange Commission for the quarter ended September 30, 2013 describes a recent acquisition and the transaction with SoftBank as follows:
On November 6, 2012, Sprint Communications entered into a definitive agreement with United States Cellular Corporation (U.S. Cellular) to acquire personal communications services (PCS) spectrum and customers in parts of Illinois, Indiana, Michigan, Missouri and Ohio, including the Chicago and St. Louis markets, for $480 million in cash. Sprint Communications agreed, in connection with the acquisition, to reimburse U.S. Cellular for certain network shut-down costs in these markets. These costs are expected to be approximately $160 million on a net present value basis, but in no event will Sprint Communications' reimbursement obligation exceed $200 million on an undiscounted basis. The additional spectrum will be used to supplement Sprint's coverage in these areas. The transaction closed on May 17, 2013. Of the total purchase price, approximately $605 million and $32 million was allocated to spectrum and customer relationships, respectively.
On July 9, 2013, Sprint Communications completed the acquisition of the remaining equity interests in Clearwire Corporation and its consolidated subsidiary Clearwire Communications LLC (together "Clearwire") that it did not previously own (Clearwire Acquisition) in an all cash transaction for approximately $3.5 billion, net of cash acquired of $198 million, which provides us with control of 2.5 gigahertz (GHz) spectrum and tower resources for use in conjunction with our Network Vision deployment and modernization project. We expect the Clearwire Acquisition will add approximately 10,000 sites bringing the total modernization project site count to be approximately 50,000. The consideration paid was preliminarily allocated to assets acquired and liabilities assumed based on their estimated fair values at the time of the Clearwire Acquisition. The allocation of consideration paid was based on management's judgment after evaluating several factors, including a preliminary valuation assessment.
On July 10, 2013, SoftBank Corp., a kabushiki kaisha organized under the laws of Japan, and certain of its wholly-owned subsidiaries (together, "SoftBank") completed the merger (SoftBank Merger) contemplated by the Agreement and Plan of Merger, dated as of October 15, 2012, as amended as of November 29, 2012, April 12, 2013 and June 10, 2013 (as amended, the Merger Agreement) and the Bond Purchase Agreement, dated as of October 15, 2012, as amended on June 10, 2013 (as amended, the Bond Agreement). Pursuant to the Bond Agreement, Sprint Communications issued a convertible bond (BOND) to Starburst II, Inc. (Starburst II) with a principal amount of $3.1 billion, interest rate of 1%, and maturity date of October 15, 2019, which was converted into 590,476,190 shares of Sprint Communications common stock at $5.25 per share at consummation of the SoftBank Merger. As a result of the completion of the SoftBank Merger and subsequent open market stock purchases, SoftBank owned approximately 80% of the outstanding voting common stock of Sprint Corporation (formerly known as Starburst II), a wholly owned subsidiary of SoftBank prior to completion of the SoftBank Merger and the acquiring company in connection with the consummation of the SoftBank Merger). The SoftBank Merger consideration totaled approximately $22.2 billion, consisting primarily of cash consideration of $14.1 billion, net of cash acquired of $2.5 billion and the estimated fair value of the 22% interest in Sprint issued to stockholders of Sprint Communications.
"The allocation of consideration paid was based on management's judgment after evaluating several factors, including a preliminary valuation assessment. The consummation of the transaction provided additional equity funding of $5.0 billion, consisting of $3.1 billion received by Sprint Communications in October 2012 related to the Bond, which automatically converted to equity at closing, and $1.9 billion cash consideration at closing. Following the consummation of the SoftBank Merger, Sprint Corporation became the parent company of Sprint Nextel Corporation (Sprint Nextel) and Sprint Nextel changed its name to Sprint Communications, Inc. (Sprint Communications). In connection with the consummation of the SoftBank Merger, Sprint Corporation became the successor registrant to Sprint Nextel under Rule 12g-3 of the Securities Exchange Act of 1934 (Exchange Act) and is the entity subject to the reporting requirements of the Exchange Act for filings with the Securities and Exchange Commission (SEC) subsequent to the consummation of the SoftBank Merger.
The most significant reference to "guaranty" or "guarantee" is described in the September 30 10-q in this context:
As of September 30, 2013, Sprint Corporation, the parent corporation, had $6.5 billion in principal amount of debt outstanding. In addition, as of September 30, 2013, the outstanding principal amount of Senior notes issued by Sprint Communications, Inc. and Sprint Capital Corporation, Guaranteed notes issued by Sprint Communications, Inc., and Secured notes issued by iPCS, Inc. (iPCS), totaling $19.7 billion in principal amount of our long-term debt was issued by 100% owned subsidiaries was fully and unconditionally guaranteed by Sprint Corporation. The indentures and financing arrangements governing certain of our subsidiaries' debt contain provisions that limit cash dividend payments on subsidiary common stock. Except in the case of notes issued by and secured by assets of Clearwire Communications LLC, the transfer of cash in the form of advances from subsidiaries to the parent corporation generally is not restricted. Cash interest payments, net of amounts capitalized of $14 million and $269 million, respectively, totaled $309 million and $912 million during the nine-month periods ended September 30, 2013 and 2012, respectively. Cash interest payments, net of amounts capitalized of $1 million and $29 million, totaled $6 million and $814 million during the 10-day and 191-day periods ended July 10, 2013, respectively. In the third quarter 2013, Sprint Corporation provided a guaranty in respect of the senior notes and guaranteed notes of Sprint Communications, Inc., the senior notes of Sprint Capital Corporation, and the Secured notes of iPCS, Inc.
There is no mention of an explicit guarantee of the debt of Sprint Corporation and its subsidiaries by SoftBank in the 10-q statements filed on June 30 and September 30, 2013. Debt maturities as of September 30, 2013 reported in the 10-q show that the company has a light year of debt maturities in 2014:
Important Note: Any legal or moral obligations by SoftBank to support Sprint Corporation and Sprint Communications, Inc. debt should be thoroughly investigated by a potential investor, whether institutional or retail. As described here, the author spent 11 years in Japan in constant communication with financial institutions in Japan. The author's experience was that lenders in Japan were much less careful with inside information than their peers in other countries. Any potential investor should assume that market participants with a Tokyo office will be aware of SoftBank's intentions with respect to Sprint Corporation and Sprint Communications, Inc. even if those intentions have not been made "public" in a Western sense.
Term Structure of Default Probabilities
Maximizing the ratio of credit spread to matched maturity default probabilities requires that default probabilities be available at a wide range of maturities. Kamakura Risk Information Services has an actively used non-public firm default probability model for non-public firms like Sprint Communications, Inc. In this note, however, we focus instead on the default probabilities of the parent company Sprint Corporation in light of the discussions above. The graph below shows the current default probabilities for Sprint Corporation ranging from one month to 10 years on an annualized basis as of both January 10, 2014 (the green line) and as of our earlier report, which used data from September 6, 2013 (the yellow line). The default probabilities range from 0.34% at one month (down 1.12% from September) to 0.25% at 1 year (down 1.34% since September) and 3.53% (down 2.05%) at ten years. This is a very, very significant improvement.
We explain the source and methodology for the default probabilities below. The default probability term structure for SoftBank is given in this graph. We present this data without any insinuations that there is an implicit guaranty by SoftBank of the debt of Sprint Corporation and Sprint Communications, Inc. Indeed, as explained below, the bonds of Sprint Communications, Inc. are trading as if there is no such assumption at all by market participants. The SoftBank default probabilities range from 0.01% at 1 month (down 0.01% from September) and 0.00% at 1 year (default probabilities are positive but rounded to 0, down 0.01% from September) to 0.38% at 10 years (down 0.04%), very significantly lower than those of Sprint Corporation.
Summary of Recent Bond Trading Activity
The National Association of Securities Dealers launched the TRACE (Trade Reporting and Compliance Engine) in July 2002 in order to increase price transparency in the U.S. corporate debt market. The system captures information on secondary market transactions in publicly traded securities (investment grade, high yield and convertible corporate debt) representing all over-the-counter market activity in these bonds. We used the bond data mentioned above for Sprint Communications, Inc. fixed rate non-call issues in this analysis.
The graph below shows 6 different yield curves that are relevant to a risk and return analysis of Sprint Communications, Inc. bonds. These curves reflect the noise in the TRACE data, as some of the trades are small odd-lot trades. The lowest curve, in dark blue, is the yield to maturity on U.S. Treasury bonds, interpolated from the Federal Reserve H15 statistical release for that day, which matches the maturity of the traded bonds of Sprint Communications, Inc. The second curve, in the lighter blue, shows the yields that would prevail if investors shared the default probability views outlined above, assumed that recovery in the event of default would be zero, and demanded no liquidity premium above and beyond the default-adjusted risk-free yield. The orange dots graph the lowest yield reported by TRACE on that day on Sprint Communications, Inc. bonds. The green dotes display the trade-weighted average yield reported by TRACE on the same day. The red dots are the maximum yield in each Sprint Communications, Inc. issue recorded by TRACE. The black dots and connecting line represent the trade-weighted credit spreads obtained by fitting a cubic polynomial to the weighted average credit spreads on each bond.
The liquidity premium built into the yields of Sprint Communications, Inc. above and beyond the "default-adjusted risk free curve" (the risk-free yield curve plus the matched maturity default probabilities for the firm) becomes very narrow at maturities of 7 years and beyond. This is the first time in this series of bond analyses that this phenomenon has been observed, but it's an improvement over the negative spread reported in September at the longer maturities.
The high, low, average, and trade-weighted credit spreads at each maturity are graphed below. Credit spreads are generally increasing with the maturity of the bonds. We have done nothing to smooth the data reported by TRACE, which includes both large lot and small lot bond trades. For the reader's convenience, we fitted a cubic polynomial that explains the trade-weighted average spread as a function of years to maturity. This polynomial explains 100% of the variation in the average credit spread over the maturity term structure since only 4 bonds were traded.
In the next graph, we compare the trade-weighted credit spreads for Sprint Communications Inc. with the trade-weighted credit spreads for Verizon Communications Inc. (VZ), the feature of a recent credit spread analysis on January 7, 2014.
The green dots are the trade-weighted credit spreads for Sprint Communications Inc. and the red dots plot the credit spreads for Verizon Communications Inc. based on bonds traded January 10, 2014. While Sprint default probabilities are sharply reduced, there is much more to do before Sprint is perceived as the same credit risk as Verizon.
Using default probabilities in addition to credit spreads, we can analyze the number of basis points of credit spread per basis point of default risk at each maturity. This ratio of spread to default probability is shown in the following table for Sprint Communications, Inc. using the very important and optimistic assumption that the default probabilities of Sprint Communications, Inc. are equal to those of Sprint Corporation. For a maturity of 3.7 years, the credit spread to default probability ratio is about 3.2 times. The ratio of spread to default probability decreases beyond that, falling to a spread to default ratio that approaches 1.0. This reward to risk ratio is the lowest of any firm analyzed in this series of bond studies, although it represents an improvement over the ratios for September 6, 2013.
We report the results from the September analysis here:
The credit spread to default probability ratios are shown in graphic form here.
The Depository Trust & Clearing Corporation reports weekly on new credit default swap trading volume by reference name. For the week ended January 3, 2014 (the most recent week for which data is available), the credit default swap trading volume on Sprint Communications, Inc. was 10 trades with $54.1 million of notional principal. The number of credit default swap contracts traded on Sprint Communications, Inc. in the 155 weeks ended June 28, 2013 is summarized in the following table:
Sprint Communications, Inc. ranked 27th among all reference names in weekly credit default swap trading volume during this period, which is graphed below:
On a cumulative basis, the default probabilities for Sprint Corporation, the parent, range from 0.25% at 1 year (down 1.34% from September) to 30.16% at 10 years, a massive 13.53% improvement over September, as shown in the following graph.
We remind the reader that we make no insinuation that SoftBank Corporation will take any actions in support of the debt of its 80%-owned affiliate Sprint Corporation or its subsidiaries. We present the cumulative default probabilities for SoftBank (with current levels shown in green) merely for the reader's convenience. The one year cumulative default probability for SoftBank is 0.00% (positive but zero after rounding) and the 10 year cumulative default probability is 3.70% as shown here. The same default probabilities for September are shown in yellow.
Over the last decade, the 1 year and 5 year default probabilities for Sprint Corporation, the parent, have varied as shown in the following graph. The one year default probability peaked at just over 60.00% in the first half of 2009 during the worst part of the credit crisis. The five year default probability peaked at more than 25.00%.
The dramatic improvements in Sprint Corporation default probabilities since September 9, 2013 are shown here:
In contrast to the daily movements in default probabilities graphed above, the legacy credit ratings, those reported by credit rating agencies like McGraw-Hill unit Standard & Poor's and Moody's, for Sprint Corporation have changed eight times during the decade, somewhat more often than the median 815 days since the last rating change for rated companies found in a recent study by Kamakura Corporation.
The macro-economic factors driving the historical movements in the default probabilities of Sprint Corporation, the parent, have been derived using historical data beginning in January 1990. A key assumption of such analysis, like any econometric time series study, is that the business risks of the firm being studied are relatively unchanged during this period. With that caveat, the historical analysis shows that Sprint Corporation default risk responds to changes in the following factors among those listed by the Federal Reserve in its 2013 Comprehensive Capital Analysis and Review:
- Change in real gross domestic product
- 3 month U.S. Treasury bill rates
- 10 year U.S. Treasury yield
- 30 year fixed rate mortgage yields
- BBB corporate bond yield
- The VIX volatility index
These macro factors explain 72.3% of the variation in the default probability of Sprint Corporation.
Sprint Corporation, the parent, can be compared with its peers in the same industry sector, as defined by Morgan Stanley and reported by Compustat. For the USA "telecom services" sector, Sprint Corporation has the following percentile ranking for its default probabilities among its 66 peers at these maturities:
1 month 71st percentile, 18 points better than September
1 year 56th percentile, 25 points better than September
3 years 55th percentile, 23 points better than September
5 years 47th percentile, 15 points better than September
10 years 44th percentile, 15 points better than September
The percentile ranking of Sprint Corporation default probabilities at one month through three years is in the third quartile of the peer group. The percentile ranking for Sprint Corporation at 5 and 10 years is in the second quartile of peer firms. Taking still another view, the actual Sprint Corporation credit ratings are "non-investment grade" by traditional credit rating standards of Moody's Investors Service and the Standard & Poor's affiliate of McGraw-Hill. The statistically predicted rating, however, is three notches above the legacy rating and it is a borderline investment grade rating.
Sprint Corporation is a complex credit, even when viewed as if SoftBank did not own 80% of the company. Before we reach any conclusions about investment grade status, we look at a comparison of credit spreads and default probabilities for sector peers and investment grade firms whose bonds traded on January 10, 2014.
We first plot the traded credit spreads for all members of the "technology, media and telecommunications" peer group with bond trades on January 10, 2014. Sprint Communications Inc. credit spreads, shown in the dark blue, are well above average for the peer group.
Sprint Corporation default probabilities, plotted on a matched maturity basis for bonds traded on January 10, are also well above the matched maturity default probabilities for the peer group on the same day.
We can do the same comparison of traded credit spreads for all bonds traded on January 10, 2014 for both Sprint Communications Inc. and all issuers with a legacy investment grade rating. Again, Sprint is well above the median of the investment grade group.
The comparison with the investment grade peer group's matched maturity default probabilities for bonds traded on January 10, 2014 shows that Sprint Corporation is still at the very highest level of the investment grade distribution.
Sprint Communications, Inc. bonds are high risk by any measure, with a cumulative probability of default over the next decade of 30.16%. While absolute risk is high, however, the default risk of the firm has dropped sharply as the benefits of the SoftBank acquisition become more obvious to market participants. This is taking place even though SoftBank has not made an explicit guarantee of the debt of Sprint Corporation and its subsidiaries.
We believe that few, if any, analysts would rate the firm as "investment grade." That being said, the statistically predicted rating from Kamakura Risk Information Services has moved up to a borderline investment grade rating 3 notches higher than the current legacy rating. The slow adjustment of legacy ratings to changes in credit quality are well documented by authors like Hilscher and Wilson (2013). Sprint appears to be one such case study.
For those investors with a high tolerance for credit risk, the next question is a simple one: does one receive enough compensation for the high default risk of Sprint Communications, Inc. that the investment is worthwhile?
In September, the answer was a resounding "no" unless one makes the optimistic assumption that the 80% owner SoftBank will step in to prevent a bankruptcy. Today, our response is more nuanced. Sprint is making rapid improvements in its default risk and liquidity, and default probabilities have moved down sharply. Credit spreads have also narrowed, but not as much, so the reward to risk ratio has improved slightly. The reward to risk ratio, however, remains very low. At current credit spreads, there has to continue to be a much greater reduction in default risk than credit spreads for the reward to risk level to be restored to normal levels.
While the possibility of a bailout of Sprint by SoftBank in the case of distress is not zero, the true possibility is likely to be well-known to large institutional investors with a presence in Tokyo long before an official announcement of intent is made. This forecast is based on the author's long experience in the Tokyo market, a time when the author was frequently given inside information without even asking about such information. This comment does not imply such information would come from the company itself. On the contrary, it is much more likely to come from lenders to SoftBank. For all of these reasons, we recommend that investors approach an investment in Sprint bonds with great caution. On the plus side, rapid improvements have been made, and a continuation would be a very profitable and happy ending for a bond investor. On the negative side, if things go bad, those who know SoftBank lenders well will have the best cards at the poker table.
Regular readers of these notes are aware that we generally do not list the major news headlines relevant to the firm in question. We believe that other authors on Seeking Alpha, Yahoo, at The New York Times, The Financial Times, and the Wall Street Journal do a fine job of this. Our omission of those headlines is intentional. Similarly, to argue that a specific news event is more important than all other news events in the outlook for the firm is something we again believe is inappropriate for this author. Our focus is on current bond prices, credit spreads, and default probabilities, key statistics that we feel are critical for both fixed income and equity investors.
Background on Default Probabilities Used
The Kamakura Risk Information Services version 5.0 Jarrow-Chava reduced form default probability model makes default predictions using a sophisticated combination of financial ratios, stock price history, and macro-economic factors. The version 5.0 model was estimated over the period from 1990 to 2008, and includes the insights of the worst part of the recent credit crisis. Kamakura default probabilities are based on 1.76 million observations and more than 2000 defaults. The term structure of default is constructed by using a related series of econometric relationships estimated on this data base. An overview of the full suite of related default probability models is available here.
General Background on Reduced Form Models
For a general introduction to reduced form credit models, Hilscher, Jarrow and van Deventer (2008) is a good place to begin. Hilscher and Wilson (2013) have shown that reduced form default probabilities are more accurate than legacy credit ratings by a substantial amount. Van Deventer (2012) explains the benefits and the process for replacing legacy credit ratings with reduced form default probabilities in the credit risk management process. The theoretical basis for reduced form credit models was established by Jarrow and Turnbull (1995) and extended by Jarrow (2001). Shumway (2001) was one of the first researchers to employ logistic regression to estimate reduced form default probabilities. Chava and Jarrow (2004) applied logistic regression to a monthly database of public firms. Campbell, Hilscher and Szilagyi (2008) demonstrated that the reduced form approach to default modeling was substantially more accurate than the Merton model of risky debt. Bharath and Shumway (2008), working completely independently, reached the same conclusions. A follow-on paper by Campbell, Hilscher and Szilagyi (2011) confirmed their earlier conclusions in a paper that was awarded the Markowitz Prize for best paper in the Journal of Investment Management by a judging panel that included Prof. Robert Merton.
Background on the Dodd-Frank Act and the Meaning of "Investment Grade"
Section 939A of the Dodd-Frank Act states the following:
"SEC. 939A. REVIEW OF RELIANCE ON RATINGS.
(A) AGENCY REVIEW.-Not later than 1 year after the date of the enactment of this subtitle, each Federal agency shall, to the extent applicable, review-
(1) any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument; and
(2) any references to or requirements in such regulations regarding credit ratings.
(B) MODIFICATIONS REQUIRED.-Each such agency shall modify any such regulations identified by the review conducted under subsection to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations. In making such determination, such agencies shall seek to establish, to the extent feasible, uniform standards of credit-worthiness for use by each such agency, taking into account the entities regulated by each such agency and the purposes for which such entities would rely on such standards of credit-worthiness.
(C) REPORT.-Upon conclusion of the review required under subsection , each Federal agency shall transmit a report to Congress containing a description of any modification of any regulation such agency made pursuant to subsection .
The new rules issued by the Office of the Comptroller of the Currency in accordance with Dodd-Frank are described here. The summary provided by the OCC reads as follows:
"In this rulemaking, the OCC has amended the regulatory definition of 'investment grade' in 12 CFR 1 and 160 by removing references to credit ratings. Under the revised regulations, to determine whether a security is 'investment grade,' banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations. Consistent with existing rules and guidance, an institution should supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution's risk profile and for the size and complexity of the instrument. In other words, a security rated in the top four rating categories by a nationally recognized statistical rating organization is not automatically deemed to satisfy the revised 'investment grade' standard."
Additional disclosure: Kamakura Corporation has business relationships with a number of organizations mentioned in this article.